Return on Equity (ROE) and Return on Capital Employed (ROCE) are popular ratios for gauging a company's financial quality. The measures try to assess how efficient and productive a company is with its money. The higher the ROE or ROCE, the better, as less funds from shareholders -- in theory at least -- are required to generate greater profits.

The denominator in both calculations can be the year-end figures or, preferably, an average based on the year-start and year-end numbers.

A major difference between the two ratios concerns debt. ROE takes it into account (earnings are calculated less interest and shareholders' funds are calculated less all borrowings), while ROCE effectively excludes it. The latter therefore tries to highlight companies producing generous returns through attractive operational assets but without the aid of financial gearing.

Investors have long debated the pros and cons of the two ratios, prompting all sorts of alternative hybrid measures to be developed over time. For the Qualiport at least, ROE is the favourite. At the end of the day, everything boils down to how much money attributable to shareholders (i.e. earnings) can be generated on the money supplied by shareholders. Generally speaking, a ROE of 15% or over is worthy of further investigation.

Apply with care

As always with investment ratios, care has to be taken with the calculation of ROE and ROCE. There are two important factors to bear in mind.

1. Goodwill: Purchased goodwill and intangibles create no end of problems for ROE/ROCE calculations. Prior to the 1998 introduction of FRS 10, purchased goodwill was written off directly to reserves and thus allowed significant expenditure to disappear into the accounting ether. Under the current FRS 10 regime, goodwill is now capitalised on the balance sheet and amortised over (usually) twenty years.

To cut a long bookkeeping story short, goodwill previously written off or amortised ought to be added back to a company's equity/capital employed figure to provide a realistic ROE/ROCE value. With less time to bring the acquisition up to speed, recent goodwill additions can depress the latest ROE/ROCE calculations. Read more on goodwill accounting, and some more.

Portfolio member Halma(LSE: HLMA) shows the difference goodwill can make. In the year to March 2003, the engineer reported earnings of £31m and average shareholders' funds of £161m. ROE therefore came to 19%. But in the accounting notes, Halma declared pre-FRS 10 written off goodwill of £77m and accumulated goodwill amortisation of £9m. Add that back to the denominator (to give £247m), and ROE falls to a 13%.

2. Write offs and exceptional items: Two more ROE/ROCE troublemakers. They may be excluded from underlying earnings and are sometimes non-cash charges, but write offs and exceptional items are a true economic cost to shareholders and can't really be ignored.

For the calculations, investors should add back asset write offs to the equity/capital employed denominator. The philosophy with exceptional items is a little trickier (as they don't always relate to balance sheet items), but adding these back to the denominator is better than ignoring them.

Qualiport share Emap(LSE: EMA) provides a good example of the problems. Normalised earnings of £125m and average equity of £227m in the year to March 2003 give a seemingly impressive ROE of 55%.

But Emap has incurred write-offs totalling £586m in the last three years, most of which related to the disastrous Petersen purchase. Exceptional items come to £27m over the last ten years while £376m of goodwill amortisation has been witnessed since 1998. Take all these into account, and Emap's ROE declines to a more realistic 19%.

Nuances

Accompanying those two issues are three more accounting nuances.

1. Revaluations: Asset revaluations increase the worth of a balance sheet but have no impact on reported profits. As such, they can unfairly depress ROE/ROCE ratios when in fact the company has actually made some canny investment decisions.

Of course, the flipside to revaluations are old assets that are in the books for next to nothing. These could flatter past ROE/ROCE figures when, in actual fact, substantial expenditure will be required for future replacements/additions.

2. Non-trading assets: Cash piles, investments and associate holdings (and the relevant income) are sometimes excluded from ROE/ROCE calculations on the grounds they aren't part of a company's core operation. But an asset must be held for a reason, no matter what type of profit it generates, and they still benefit shareholders in real life. To paraphrase Bill Shankly: "If an asset is not interfering with trading or seeking to gain an advantage, then it should be."

3. Provisions and minorities: A provision is (arduously) defined as 'an amount retained to provide for a liability or loss which is either likely to be incurred, or certain to be incurred but uncertain as to the amount or as to the date on which it will arise'. The amount is deemed a liability on the balance sheet, though the company in practice still benefits from the cash set aside. As such, provisions ought to be added back to the ROE/ROCE denominator.

Minority interests occur when a parent company has one or more controlled subsidiaries that are not wholly owned. The after-tax profits and assets associated with minority shareholders are disclosed in the main financial statements and should be excluded from the 'majority' shareholders' ROE ratio. But the idiosyncrasies of accounting mean minority interests aren't revealed at the operating profit level, nor itemised on the balance sheet, so ROCE fans will have to do some guesswork. Read more on provisions and minorities.

Summary

ROE and ROCE are pretty good indicators of superior businesses, but numerous accounting issues make them far from perfect. The incremental return on equity calculation tries to iron out some of the problems, but it can develop into a statistical nightmare even faster.

Still, broadbrush calculations will often suffice, with companies that have consistently reported high ROE/ROCE ratios making good starting points for further research. Remember, though, that past accounts will never answer the key investment question: whether or not the good returns of the past will continue well into the future.

Trading Update

Following a statement this morning, the Qualiport will dispose of its entire holding of DFS Furniture(LSE: DFS) within the next five trading days. Next week's Qualiport -- now every Tuesday -- will explain further.